🧐 Why is RBI after NBFCs?

NBFCs are growing bigger by the day. Here’s how they pose a risk to the entire economy.

Remember when we were back in school, every time anyone made a big mistake, the whole class was punished? The teachers set stricter rules and often even reshuffled the seating arrangements. 

Well, the RBI has now taken a cue from our teachers and introduced a new framework to regulate Non-Banking Financial Companies (NBFCs). 

But why does RBI, the banker of all banks, have power over a non-banking company? 

While you can’t deposit or withdraw money from NBFCs as you do at banks, they still offer a whole host of financial services. 

NBFCs provide housing loans, microloans and several different kinds of instruments. They even take higher risks and lend money to those whom the banks won’t even think of lending. All in a bid to get higher returns. 

So, a business that deals with so much public money, has the potential of impacting the economy in a big big way. If anything untoward were to happen, who would be responsible? Thus, the NBFCs have been operating under the RBI’s nose since 1964.

But the rules made for NBFCs were more chill than the rules made for banks. After all, NBFCs weren’t that big. 

However, things have changed. The NBFC sector has been growing at a breakneck speed. From holding just 12% of the assets that banks held in 2010, they are now over 25% of the size of banks.

Source: Discussion Paper of RBI

In the last couple of years, banks have loaned out more money than usual to NBFCs. 

Hang on! Banks lend money to NBFCs?

Yes. Ironic. Isn’t it?

In March 2019, bank lending accounted for 29.2% of NBFC borrowings as compared to 21.2% in March 2017. This quick flow of cash led to NBFCs loaning money to anyone and everyone.

But… not everyone could pay back this money. And, this created the perfect recipe for disaster.

Many big NBFCs owed large amounts of money to lenders. Infrastructure Leasing & Financial Services (IL&FS), the first major NBFC to default on its payments, had a debt of over Rs. 94,000 crores! 

Lenders suddenly began facing a liquidity crunch. And this caused ripples that impacted the entire economy. The episode also shook people’s faith in NBFCs, making the crisis even worse for the sector.

Now, the RBI couldn’t simply sit back and watch. So it stepped in to take control. The lax attitude with NBFCs had to go now.

New Framework

It has introduced a new framework, in which NBFCs will be classified and put into 4 different layers. Umm, what?

You see, not all NBFCs carry the risk of taking others down, or bringing upon a wide-scale catastrophe. For example, a P2P NBFC, which is just a match-maker between loan provider and loan taker (peer to peer), or an Account Aggregator NBFC, which just compiles financial information of people, are put in the lower (less attention needed) layer. 

But the ones that borrow a large amount of money from the public and are connected to many other financial institutions like banks, any defaults on their part will have a huge impact on the economy. So, the RBI will monitor and regulate these NBFCs closely by placing them in the topmost layer or the Upper Layer. Yep, just like how the troublemakers in your class were forced to sit on the first bench so the teacher could pay more attention to what they are doing.

Financing of IPOs

The RBI has also set a limit on the amount of money that high net-worth individuals can borrow from NBFCs to invest in IPOs.

Yep, you read that right. Unlike you and me, stock market biggies take loans from NBFCs to bet on IPOs.

You see, banks already have a limit of Rs.10 lakh on IPO financing. But NBFCs did not have any such limit. So they could tap into the richie-rich (HNI - High Networth Individual) segment. 

But, what would happen if these IPOs didn't perform well? (remember SBI Cards?) HNIs would have a difficult time repaying the amount. This would increase the risk of bad loans for NBFCs. The new limit, which is set at Rs. 1 crore, will help reduce this loss. And here comes the interesting bit...

This move is also beneficial for us, the retail investors! High net worth individuals will now have less money to put into IPO allotments. This will reduce the price volatility in IPO shares as there will be a lesser number of shareholders who tend to cash in on IPO gains on listing day, causing the stocks to crash. 

But, this limit will be effective from April 2022. So don't get your hopes up for getting allotments in Nykaa and Paytm's IPOs!

All in all, the RBI is trying to make the NBFC space more secure and reliable. But do you think these revised rules will be able to prevent another IL&FS kind of episode? Would this really make them safer?

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